P. Post Issuance and Arbitrage Compliance Presented by: BLX Group LLC Robin Schlimgen, Managing...

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Post Issuance and Arbitrage Compliance

Presented by: BLX Group LLC

Robin Schlimgen, Managing Director, [email protected]

BLX Group LLC 1910 S. Stapley Drive First Floor, Suite 115 Mesa, AZ 85204 ph: 480-539-4084www.blxgroup.com

http://www.blxgroup.com/

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Discussion Outline

• Post-Issuance Compliance Overview• IRS Enforcement Update• Arbitrage Overview• Record Retention Requirements• Additional Resources

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Post-Issuance Compliance Overview

“Post-issuance tax compliance begins with the debt issuance process itself and provides for a continuing focus on investments of bond proceeds and use of bond-financed property.”

After the Bonds Are Issued Then What?

Advisory Committee on Tax-Exempt and

Governmental Entities

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• Issuers and conduit borrowers must comply with federal tax rules for the life of the original bonds and any refunding bonds

• Easy for borrowers to lack adequate records and detailed information to defend themselves in an IRS audit challenging the tax-exempt status of bonds

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Elements of an effective Post-Issuance Compliance Program

•Designation of tax compliance point person(s)•Communication with outside tax specialists•Continuing education and training•Record retention policies and procedures•Periodic review of policies and other contracts

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Elements of an effective Post-Issuance Compliance Program

•Investment of bond proceeds•Accounting for expenditure of bond proceeds•Arbitrage rebate and yield restriction monitoring•Monitoring the use of bond financed property• Addressing changes in use of bond financed property

through self-help remediation and VCAP• Written guidelines and procedures

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What is the Purpose of a Post-Issuance Tax Compliance Policy?• Demonstrates to the IRS that you are taking your post-

issuance compliance responsibilities seriously• Assigns responsibility for certain tasks and

responsibilities to specific individuals or departments• Provides you with a compliance framework in which to

work without burdening you and your staff with too much detail

• Memorialized processes and activities to aid in the event of staff turnover

• Reduces risk of IRS winning willful neglect case

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What should be included in a Post-Issuance Tax Compliance Policy?•Use of tax-exempt bond financing description• Designation of post-issuance tax compliance point

person(s)• Tax-exempt bond tax law compliance requirements

(including arbitrage and yield restriction)• Record keeping requirements• Annual review and training• Frequency of internal compliance checks

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IRS Enforcement Update

Why should you care about the IRS post-issuance compliance initiative?

• Defending tax-exempt status of bonds in an IRS audit is expensive and time consuming

• Reputation in credit markets • Financial settlement to protect bondholders would be

costly

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IRS Focus on Post-Issuance Compliance Activities

• IRS is looking to ensure that the federal subsidy provided by the interest exclusion on tax-exempt bonds is properly applied

• Increase in staff – currently around 100 agents• Audits – looking at 300 to 400 issues at a time, planned

to close up to 1,500 audits in 2013• Random/Targeted/Market Segment Identification• Compliance Check Questionnaire Initiative

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2013 TEB Work Plan• Encourage greater participation in self-correction and

voluntary compliance programs (VCAP)• Respond promptly and appropriately to abusive arbitrage

motivated transactions• Enforcement and Compliance Reviews

• Market segment examination work• Arbitrage focused exams will cover rebate payment

verification• Compliance checks evaluating policies and procedures

• Guidance, Education and Outreach• Greater understanding of tax responsibilities

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Market Segment Identification• Identify areas for exam based on financial structure,

type of bond or industry/function• Improve focus and efficiency of the exam• Every year: advance refunding, 8038-T(rebate),

TRANs, 501(c)(3) bonds, small issue manufacturing and solid waste

• Each year will select other areas, e.g. airports, cities• Identify area of greatest likelihood of violation

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IRS Compliance Check Questionnaire Program• “Soft contact” approach program (non-audit)• Allows the IRS to obtain a lot of information inexpensively

Theme of Questionnaires• Policies and Procedures• Record Keeping• Investment and Arbitrage Compliance• Expenditures and Assets• Private Business Use• Training

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Form 4564 – Information Document Request (“IDR”)

• Attached to Notice of Examination Letter• Relates to Examination of one specific bond issue• Examination may end in:

- No Change Letter- Issuer and IRS Closing Agreement with settlement- Determination that bonds are taxable and audit and taxation of

bondholders

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TEB Report March 8, 2013

Avoiding Troubled Tax-Advantaged Bonds, A Study of Issuer Compliance Considerations

• Phase I - Pre-Issuance – hiring the right professionals for your bond transaction, checking conflicts, etc.

• Phase II – Transaction Execution – getting the best price for your bonds

• Phase III – Post-Issuance – • Establishing responsibilities – “institutional knowledge” • Accounting for Proceeds – expectations of use vs. actual• Monitoring Arbitrage • Establishing continued compliance

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Arbitrage Overview

• Arbitrage Rules - Governed by Section 148(a) of the Internal Revenue Code – two different requirements

• Yield Restriction - Tax Reform Act of 1969

• Arbitrage Rebate - By 1986 all of tax-exempt debt included

• Reason for Regulations: System was abused

• Laws and regulations were established to discourage issuers from:

• Issuing more bonds than needed

• Issuing bonds sooner than needed

• Leaving bonds outstanding longer than needed

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Arbitrage Overview

Arbitrage Defined

• Ability to borrow at tax-exempt rates and invest at higher taxable rates without incurring any additional risk

Arbitrage Simplified

• The differential between the bond yield and the yield on taxable investments

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Arbitrage Overview

• Advance Refunding Bonds – two sets of Bonds outstanding simultaneously – subject to arbitrage rules separately

• Upon issuance – Required to be in compliance with yield restriction, rebate, and record retention

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Arbitrage Overview

• Two separate requirements though related

• Need to comply with both requirements to avoid bonds being

declared “Arbitrage Bonds”

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ArbitrageRebate

Yield Restriction

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Arbitrage Overview

Rebate Requirements• Excess earnings on “non-purpose” investments allocated to

gross proceeds• Issue by issue determination• Positive arbitrage can be offset by negative arbitrage within a

particular bond issue• Computation Date Credit offset to defray the cost of the

calculation (2014 = $1,620)• Compliance for the life of the bond issue

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Arbitrage Overview

Rebate Requirements• Why would you want to owe rebate?• Rebate payments are required to be paid no later than 60

days after each 5th “Bond Year” and 60 days after the final redemption date

• Bond Year defined as each 1-year period that ends on the day selected by the issuer

• First and last bond years may be short periods• My bonds have been refunded, do I still need to perform

rebate calculations?

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Arbitrage Overview

Need to Determine……

• What is the maximum rate of interest I can earn and retain? (Fixed/Variable Bond Yield)

• What proceeds are subject to the arbitrage rebate requirements?

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Arbitrage Overview

Gross Proceeds

Sale Proceeds• Proceeds derived from the sale of the bonds

Investment Proceeds• Earnings received from Sale Proceeds and earnings

on those earnings

Original Proceeds• Includes Sale Proceeds and Investment Proceeds

Transferred Proceeds

Replacement Proceeds• Sinking & “pledged” funds

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Arbitrage Overview

Other Important Considerations

• Commingled Funds – fund including variety of sources, invested without regard to source

• Reimbursement – requires official intent• “Allocate Proceeds to Expenditures” vs “Spend

Proceeds”

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Arbitrage Overview

Exceptions to Rebate• All or a portion of the bond proceeds may be excluded from

the arbitrage rebate requirements if they meet a spending exception

• If you earned positive arbitrage and met a spending exception you are allowed to keep the earnings

• Six-Month Spending Exception• 100% spent within six months• Another six months for de minimis amount (less than 5% of

proceeds of issue)• Only exception available for refundings

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Arbitrage Overview

Exceptions to Rebate• Eighteen-Month Spending Exception

• Permitted under 1993 Regulations (not retroactive)• De minimis allowance of lesser of 3% of issue price or

$250,000• Spending requirements

15% in 6 months

60% in 12 months

100% in 18 months

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Arbitrage Overview

Exceptions to Rebate• Two-Year Construction Spending Exception

• Became available in 1989 Code (not retroactive)• Fairly limiting as only applies to construction issues (75%

or more used for construction purposes)• De minimis allowance of lesser of 3% or issue price of

$250,000• Time extension for reasonable retainage• Spending requirements

10% in 6 months

45% in 12 months

75% in 18 months

100% in 24 months

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Arbitrage Overview

28 Exceptions to Rebate• Small Issuer Exception

• Permitted under Code since 1986 and finally added to Regulations in 1993

• General taxing authority Bonds issued during a calendar year

• $5,000,000 limitation (Subordinate entity debt included)• Private activity bonds - no small issuer allowance• Is NOT an exception for Yield Restriction or Post

Issuance Compliance• Public Education limitation

• $5,000,000 prior to 1998• $10,000,000 1998 to 2001• $15,000,000 2002 to present• No more than $5 million can be used for non-construction

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Arbitrage Overview

Exceptions to Rebate• Bona Fide Debt Service Fund Exception

• Proper matching of revenues to principal and interest payments within each bond year

• Annual depletion requirement to bring account balance below a reasonable carryover amount

• Reasonable carryover amount is 1/12th of preceding year’s debt service payments

• Private Activity bonds have additional $100,000 earnings test -- If bona fide debt service fund earns less than $100,000 in a given bond year it shall not be taken into account for rebate purposes

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Arbitrage Overview

Build America Bonds (BABs)• Governmental bonds eligible for certain tax advantages• New money capital expenditures only• Issuer elects to issue bonds as taxable• Tax Credit Bonds

• Purchaser receives tax credit of 35% of interest• Accepts lower yield on bonds

• Direct Pay Bonds• Issuer receives tax credit of 35% of interest payment• Form 8038-CP filed to retrieve tax credit• Still subject to rebate

• Program ended December 2010

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Arbitrage Overview

Yield Restriction• Issue by issue determination• Restricts investment earnings relating to Yield Restricted

Proceeds• Temporary Period - 3 Years (Project Fund) – certify at closing

that reasonably expect to spend more than 85% in 3 years• Advance refunding and defeasance escrows• Transferred proceeds• Amounts in excess of reasonably required reserve funds

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Arbitrage Overview

Yield Reduction Payments• Apply to bonds issued on or after July 1, 1993, or bonds

retro-actively applying the 1993 Regulations• Similar to rebate payments - pay positive arbitrage on

yield restricted proceeds• Pay 90% of yield restriction liability at every fifth bond

year, and 100% at the final maturity• Can owe a yield reduction payment without owing a

rebate payment• Made in the same time and manner as rebate payments• Does not result in “double” payments

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Arbitrage Overview

Exceptions to Yield Restriction• Temporary period• Materially higher yield allowance

- Unexpended Construction 1/8th of 1%- Refunding Escrow – 1/1000th of 1%

• Minor portion – lesser of 5% of issue price or $100,000

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Arbitrage Overview

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Yield Restriction Arbitrage Rebate

Tax Reform Act of 1969 Tax Reform Act of 1986

Purpose and Non-purpose Investments

Non-purpose Investments

Materially Higher Yield Bond Yield

Temporary Periods Issue Date

Minor Portion Exception Certain Exceptions (Spending, BFDSF, Small Issuer)

Yield Reduction Payments Rebate Payment

Computation Credits

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Arbitrage Overview

Documents Required for Arbitrage• Final Official Statement• Tax Certificate• IRS Form 8038-G/8038• Trust Indenture• Verification Report (if applicable)• Other Special Documents (Investment Agreement, Swap

Agreement, etc.)• Copy of 8038-T/Check (if applicable)• All Investment Data (entire calculation period)

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Arbitrage Overview

Does Reporting Ever Stop?• Calculations are required every five years and at the final

maturity date of the issue.• A refunding may accelerate the final computation date• Arbitrage requirements may cease for outstanding bonds if

all the following criteria is met:• All bond proceeds have been spent• No Reserve Fund has been funded• Debt Service Funds are 100% bona fide (Bona Fide Debt

Service Fund Exception) and non-governmentals earn less than $100k in a bond year

• No other proceeds arise:• Replacement• Transferred Proceeds

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• Loss of tax-exempt status

• 50% (100% for private activity bond) penalty and late interest on underpayment

• Waiver of 50% penalty under certain circumstances

• Not willful neglect

Arbitrage Overview

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Record Retention Requirements

How long must records and source documents be maintained?

• Minimum 3 years after bonds are retired• Extended to 3 years after refunding bonds are retired, if the

bonds were refunded• Older requirement in most tax documents require a 6 year

retention policy

Determine the Storage Medium• Paper – must be kept for the long term• Electronic – must meet requirements of Revenue Procedure

97-22 and keep technology up to date

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What records must be maintained?• Documents related to the bond transaction (entire transcript)• Documents related to post-closing elections

• Bond Year Selection• Retro-Active or Selective Application of Regulations

• Documents evidencing any investment of bond proceeds• Trust Bank Statements• Internal Records

• Documents evidencing expenditure of bond proceeds• Use of bond financed property by public and private sources• Sources of payment or security for the bonds• Arbitrage Reporting – Rebate and Yield Restriction

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What if records not maintained?• Loss of tax exemption• Additional rebate could be due (based upon IRS

conclusions)• Failure can be corrected through - Voluntary Closing Agreement

Program (TEB VCAP) - Must be filed prior to Audit• VCAP team --- about 20 agents

Where to find assistance:• Access NABL/GFOA websites to use as a starting point or

for additional support • Visit IRS Website

• http://www.irs.gov/Tax-Exempt-Bonds/Tax-Exempt-Bond-FAQs-Regarding-Record-Retention-Requirements

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Additional Resources

IRS Website – Access to Forms and Information• Form 13907 - 501(c)3 Questionnaire

http://www.irs.gov/pub/irs-tege/f13907.pdf

• Form 14002 – Governmental Bonds Questionnaire

http://www.irs.gov/pub/irs-tege/f14002.pdf

• Form 14127 – Build America Bonds Questionnaire

http://www.irs.gov/pub/irs-tege/form_14127.pdf

• Tax Exempt Bond Forms and Publications

http://www.irs.gov/Tax-Exempt-Bonds/Tax-Exempt-Bonds-Forms-and-Publications

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P. Post Issuance and Arbitrage Compliance Presented by: BLX Group LLC Robin Schlimgen, Managing...

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